Will East Asia suffer the US slowdown?

In the past few years, the world economy has done very well. Almost every nation has grown richer. In the last six months, however, bad news has been pouring in.

In the US, the housing bubble[1] burst. The value of houses fell (by 9.1% just last December), triggering defaults in the sub-prime mortgage[2] market and unfolding a financial turmoil. The banking system - uncertain about where, and how big, the risks are - put on the brakes, and got credit into a crunch. In simpler words, banks now lend very carefully, and getting a loan is not as-easy-as-it-was one year ago. To ease borrowing and kickstart a recovery, the Fed[3] has intervened[4] and drastically lowered interest rates to 3%. Meanwhile, the US dollar keeps depreciating[5] vis-à-vis the other major currencies. The steady sell-off of dollars on the currency markets is triggered by grim expectations about the economic outlook and by the chronic twin deficit, that is: a) a deficit in the current account (i.e.: the country is importing more than it is exporting); and b) a deficit in the public budget (i.e.: the fiscal revenues don’t keep up with expenditures). The economy is in dire straits: inflation is skyrocketing (in January, prices jumped by 13.5% for producers and 6.4% for consumers). Jobs are being lost (January witnessed the first net loss in 4 years). Consumer confidence, income, and sales are distressed. Bottom line: for all the above reasons, a US recession is possible.

In the high-income countries, economic growth is easing (except for Japan), due to lower internal demand (i.e.: consumers spend less, as they are worried about tomorrow), decelerating industrial production, and declining exports. For example, in Europe, a strong Euro and weaker US demand are taking a toll. Additionally, the US credit crunch is going global: sub-prime losses (up to $150 billion, for now) hit a few big international banks. As a consequence, credit conditions are getting tighter everywhere. Equity markets are increasingly volatile, and stocks tumbled badly in January, when $5.2 trillion were burned and emerging markets lost more than 10%. In Europe and in the US the risk of companies defaulting on their debt is now higher than ever. Finally, inflation is taking a painful toll everywhere (and limiting the action of fiscal[6] and monetary[7] policies), because of the rising prices of energy and food. The price of oil jumped to more than $100 a barrel. Coal prices are soaring. Food is becoming more and more expensive: while grain (corn, soybeans, and wheat) stocks are low, the cost of key farming inputs - energy and fertilizer - is high. The markets are rushing to secure assets - a safe hedge against inflation: the price of gold soared to more than $960 an ounce, a record high. The value of silver is the highest in thirty years.

Is this a storm in the making?
The answer to this question depends on where you stand in the current debate.
If you think the US economy has still a lot of influence on the world economy, you might fear dire global repercussions from the US slowdown. If you forgive my oversimplifying, here is a rough metaphor: if the world were to be a ‘family’, you would look at the US as the ‘bread winner’; and sure, when such a key person “gets sick”, the flu spreads, and the family is in trouble. Otherwise, if you think the US economy is not as influential on the rest of the global economy as it used to be, you might believe that the developing world will get by, even if the US is struggling or in a recession. In the above metaphor: “the kids have grown up”; the poor(er) countries can now make it on their own, and will keep growing fairly robustly - even with weaker prospects in industrialized nations.
Let’s analyze the two positions with some detail:

The developing economies will suffer the US turmoil, because they are interlinked – via economic and financial ties - with the high-income countries. Some commentators feel that for the developing world the key-word is “export”. For them, local growth comes - above all - from selling to the industrialized countries what they need: energy, commodities, and electronics (think of oil, coffee, and cheap computers, and you will get their point). In other words, the demand in rich countries is what drives production – and growth - in poor(er) nations. In the global economy these links are so deep, that the performance (i.e.: in terms of consumption) of the industrialized economies is crucial for global prosperity. Hence, a likely recession in the US (the world’s biggest consumer market) and mounting uncertainty in high-income countries should get us really worried about the developing countries and the global economy. A crisis is highly plausible. This is the view, for example, of the recent UN “World Economic Situation and Prospects 2008”[8], and of Martin Wolf[9], in recent Financial Times columns (see Article 1[10] and Article 2[11]).

The developing economies will get by, because they are well advanced in the process of de-linking from the industrialized economies. Other commentators feel that the developing economies have become resilient[12], i.e. able to operate and prosper despite the turmoil. The keyword here isn’t ‘export’, but “domestic demand”: the engine of local growth is a strong domestic spending – so strong that it could even offset a decline in exports to high-income countries. In other words, the emerging economies ‘are fine’. Over the years, they have grown vigorously, improved their macroeconomic stability, and accumulated large foreign exchange reserves. Also, they are increasingly trading amongst themselves: for example, China has replaced the US as India’s largest supplier of imports. In Russia, India and Brazil, imports are growing faster than in the US. In short, the emerging economies - driven by the rapid growth of China and India – are less tied to the industrialized world, and more interdependent. This is the view, for example, of the recent IMF “World Economic Outlook[13]” (for the IMF, in 2008 developing countries will grow at 6.9%, and China at 10%), of the latest World Bank “East Asia Update”[14], and of a couple of recent posts in this blog (see Justin Lin Yifu[15], the new World Bank Chief Economist, and David Dollar[16] on China).

Which of the two positions is more convincing?
Of course, picking just one might not be the right choice. The truth - in today’s world economy - is that both 1. and 2. above are strong forces in interplay, happening at the same time. The key point is to understand which one will get the upper hand.
And what about East Asia? At first glance, the region should have limited exposure to sub-prime mortgage securities[14], and a fair amount of liquidity in the domestic economies. Moreover, the latest data don’t point to a slowdown related to the US economic struggles. Indeed, in the US, in the last three months of 2007, imports weakened and the economy decelerated from 4.9 to 0.6%. Over the same period, in Japan growth raised from 1.3 to 3.7% because of strong exports, mainly to East Asian neighbors. In the Philippines, imports grew at 19.7% and the economy at 7.4%. In Korea, growth went from 5.2 to 5.5%. In Malaysia, the economy expanded at 7.3%, benefiting from higher commodity prices and increased government spending. The Thai economy also accelerated to 5.7%, pushed by robust exports. Growth cooled a little in China (from 11.5 to 11.2 %, because of lower exports) and in Indonesia (from 6.5 to 6.3%), and decelerated in Singapore (from 9.5 to 5.4%). In short, in East Asia economic growth held up well, mainly pushed by strong domestic demand. However, it is too early to declare victory.
What is my position? I tend to be optimistic, and think that East Asia will get by. This is not to say that there is nothing to worry about.
The worst case scenario - a global financial crisis leading to a world recession - is indeed possible. The ongoing depreciation of the US dollar might have risky consequences, as the big global imbalances are still there. First, in East Asia the central banks have amassed huge foreign currency reserves, held mostly in dollars. A weaker dollar will reduce the value of these reserves, and erode their “protective buffer” against a potential financial panic and a prolonged recession. Second, more than 20% of China’s exports go to the US, and about 54% to the high-income economies; sooner or later, the decreased purchasing power of the dollar and the global slowdown might take their toll. Finally, the next round of sub-prime losses could fall on small financial institutions in the developing world.
But such a scenario, while possible, doesn’t seem the most likely. Today, most East Asian countries face a favorable outlook: a strong domestic demand, sound macroeconomic conditions, and buoyant commodity prices. And the de-linking from the western economies – if not (yet) well under way – seems at least to have started. Here – once again – the price of oil can be used as a revealing indicator. While, in the past, a US recession brought about a reduction of oil and other commodity (i.e.: metal) prices, this is not what’s happening today. Actually, it’s just the opposite: this might show that global demand is still strong, and that the demand in the emerging markets doesn’t depend much on international factors.
Would you agree? Or you think that there is trouble ahead for East Asia?
If you are interested on how will East Asia react to this storm, stay tuned. This blog, and - in late April - the new World Bank “East Asia Update”[14], will provide you with the latest data and analysis.